Because the earnings in a Roth Individual Retirement Account–also known as a Roth IRA–are shielded from taxes, high earners are not allowed to directly contribute to them. For these high earners, a backdoor Roth IRA can serve as an avenue to boost their income during their retirement years.
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An IRA is a specially designed investment vehicle designed to encourage individuals to save money for retirement. There are multiple types of IRAs, with the most common being Roth and Traditional IRAs. Though both types of IRAs follow many of the same principles, there is one fundamental difference between the two: the timing of the tax obligations.
What are IRAs?
Prior to examining the mechanisms of a backdoor Roth IRA, it is important to understand how an IRA functions.
The two most common types of IRAs are the Traditional and Roth IRAs. Both of these savings accounts are designed to encourage individuals to invest monies for retirement through both carrots and sticks. To incentivize savings, there are tax breaks offered, while on the flip side early withdrawal–defined as prior to age 59.5–will usually be penalized. (For a full discussion of IRAs, see All About IRAs — Individual Retirement Accounts.)
The important distinction between a Traditional and Roth IRA is the order of the tax liability. For Traditional IRAs, the monies contributed every year are deducted from the taxes owed. The withdrawals, which are known as distributions, will therefore be taxed as ordinary income tax during these later years.
For Roth IRAs, this order is reversed. There is no tax break in the years when the monies are contributed. However, these monies will grow tax free during the ensuing years and the subsequent distributions will not be taxed. For those who are investing large sums of money over long periods of time, the tax savings can be significant as the wonders of compound interest work their magic.
In addition to the tax benefits, there are no Required Minimum Distributions for a Roth IRA, which is another advantage of a Roth IRA.
What are the Contribution Limits to IRAs?
There are limits to the amount of annual contributions that individuals can make to both a Traditional and Roth IRA. The maximum amount that anyone can contribute on an annual basis for 2024 is $7,000, though this rises to $8,000 for those over the age of 50. However, because Roth IRAs have such significant tax benefits, there are income limits that prevent higher earners from contributing directly to them.
This is a sliding scale that the U.S. Internal Revenue Service publishes, and for 2024 the limits are $161,000 for individual tax filers and $240,000 for those married and filing jointly. In other words, if you are earning income at these levels, you are not allowed to make direct contributions to a Roth IRA.
There are no income limitations placed on Traditional IRAs.
What is a Backdoor IRA?
A backdoor Roth IRA is actually a standard Roth IRA. The “backdoor” refers to the manner in which high income earners will contribute monies to their Roth IRA. In practice, this means that the individuals will transfer monies from their Traditional IRA or their 401(k) accounts into a Roth IRA.
Most brokerages who manage IRAs can help you manage this process, helping you to roll these funds into a Roth IRA. This is considered a taxable event, as the monies that you have contributed to both Traditional IRA and Traditional 401(k) accounts were not previously subject to taxes. In addition to the monies that you have directly contributed, you will also need to pay tax on the earnings that these monies have accrued.
The tax implications become extremely tricky when you have both after-tax and pre-tax contributions in your accounts. In these cases, you will be taxed on a pro-rata basis. Because the U.S. Internal Revenue Service considers all of your IRAs as one taxable entity, you will be taxed according to the percentage of your funds that were contributed before taxes throughout all of your IRA holdings.
Remember, this will be taxed as ordinary income taxes, meaning that your tax burden for the year in which you make this conversion, will increase.
Conclusion: How to Consider the Pros and Cons of a Backdoor IRA
A Roth backdoor IRA can serve as a good solution for those making above the income limitations to contribute to a Roth IRA, but who still want to enjoy the benefits of a Roth IRA.
In essence, the biggest advantage of this strategy is that it will allow you to enjoy the after-tax benefits of a Roth. Because you will have already paid taxes on these monies, your investment earnings will grow tax-free and you will not be on the hook for any tax obligations once you begin taking distributions.
There is also no Required Minimum Distribution for Roth IRAs, allowing you to keep your assets invested and pass them along to future generations.
If you are considering pursuing this strategy, it is always a good idea to consult with a tax professional, who can help guide you through the nitty-gritty details of the process to better understand your expected tax burden.
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